The implications of combining excess supply of capital with the war for talent in the digital economy

The world of early stage investing is changing in ways that are reminiscent to the tech bubble of 1999. As Fred Wilson points out in “Storm Clouds” that investors are behaving badly, making $5M to $15M investments in web startups in days, without proper due diligence. Even larger web companies like Facebook and Google are contributing to the madness, paying tens of millions of dollars to acquire companies to shut them down, just to get access to their engineers. According to a story by Mike Arrington, Google even gave an engineer a $3.5M package to stay with the company. Are we in another bubble that’s about to burst and take us all with it? What does this all mean for entrepreneurs, engineers, investors and startups?

I believe we can use the simple laws of supply and demand to understand the situation and give ourselves a framework we can use to better prepare ourselves for what lies ahead

We can look at our ecosystem as the combination of two markets: the startup market and the IT market. By IT market I mean large companies in the greater IT sector (web, Internet, mobile, software, gaming, advertising, etc.) such as Google, Apple, Microsoft and Facebook that are an integral part of the startup ecosystem. Both markets need the same basic resources to thrive: infrastructure (computing power, storage and bandwidth), customers or revenues, capital (angels, VCs and public markets), ideas/products and talent (engineering and management). The two markets have also had a symbiotic relationship over the years that is now at risk due to an important imbalance in the supply and demand curves of capital and talent. For years, startups have been considered a resource in the larger IT market. Large IT companies have used startups to fill gaps in their product roadmap (ideas/products) and acquire qualified engineers (talent). Large IT companies have also been a major part of the startup market either as partners, customers, competitors, investors or acquirers, fueling the virtuous circle that makes the startup ecosystem viable.

There is an oversupply of capital in both the startup and greater IT markets, with no end in sight except for growth capital, unless we experience another collapse of our financial system.

In the startup market, capital comes mostly from angels, Super Angels and venture capital funds at the early stages. As companies expand, they can tap into other sources of capital such as strategic investors, financial institutions, public markets and mergers and acquisitions to grow or provide liquidity to shareholders. In the IT market, capital comes from a number of sources including public markets, financial institutions, mergers and acquisitions and cash flow from operations. There is currently excess capital in the both the startup and the IT market.

The supply of capital at the seed level in Silicon Valley and some of the top US markets outpaces demand by a large margin for web companies. The sharp increase in the number of new startups that we’ve been experiencing since 2005 has been met by a massive decrease in the amount of time and money it takes them to reach market validation. As a result, the startup ecosystem doesn’t need more capital than before to thrive, I would argue that it needs much less. At the seed level, which I define as a company that as yet to achieve market validation, a horde of angels and Super Angels have entered the fray. Even if these investors have less investment requirements than venture capitalist (smaller investments, lower exit thresholds, broader sectors) and will end up investing in a lot more deals as a group, most of the capital invested at this stage will be concentrated on a small fraction of the startups. As stock markets continue to be volatile and we start to see more exits however small, we should see a steady increase in angel investing activity, resulting in even more capital in the market. More capital means higher valuations, bigger seed rounds that close faster, and less reliance on VCs to get companies to exit. In addition, many VCs already invest at this stage and more will do so over the coming years, further increasing supply. The good projects will continue to be oversubscribed and the decent ones will continue to get funded for years to come, keeping the market in an oversupply state for years. This doesn’t mean that most companies won’t fail, like they historically do, but we may end up with more companies getting to the breakeven point.

There is an oversupply in growth capital that should ease within the next 5 years. Less than 5% of the thousands of new startups being created each year are solving big enough problems to aspire to one day achieve enough scale to sell for $100M or more, which is the threshold for 95% of the venture capital industry. More startups doesn’t mean more large exits. These few companies also need less capital than before to reach each value creation milestone (market validation, repeat customers, hyper growth, profitability, market leadership, etc.) resulting in excessive competition for the few who fit the profile. Another dynamic at work is that because of terrible returns since 1999, the venture industry is at a crossroads and most firms will not be able to raise another fund unless they invest in the next Facebook. This reality is driving many VCs to make “hail mary passes” the cornerstone of their investment strategy. As far as they’re concerned, these funds have nothing to lose. The combination of these factors has resulted in a sharp increase in valuations at the post-seed level (Gowalla, Blippy and Foursquare are glaring examples) and irresponsible behavior by venture capitalists on “hot deals” as documented in Fred Wilson’s post. Most of the venture funds currently investing have less than 2 years remaining to their investment period, which should translate into an important drop in available growth capital for startups over the next few years. That being said, with so much capital on the sidelines with nowhere to go, I suspect angels and financial institutions could pick up the slack, especially for the companies that have market validation, keeping the market at an equilibrium.
There is an oversupply of capital in the IT market and it should remain this way for the foreseeable future. In the IT market, companies like Google, Microsoft, Oracle, Cisco and Apple are sitting on record amounts of cash. Most of them are very profitable, still growing, have scalable business models and no debt. There is no reason for this situation to change in the short to medium term.

There is an important lack of talent supply in both the startup and IT markets and its unlikely to change in the short to medium term.

We live in a digital economy. The web is everywhere. It has become a key part of our lives and is becoming a cornerstone of each of our industries. Big web companies like Google, Facebook, Apple, Microsoft are engaged in an all out war for talent, as expressed by Eric Schmidt in a recent interview, that should last for years as they compete from web supremacy, but they are not alone. Consumer facing companies like Proctor & Gamble, Ford and Coca-Cola have started hiring as well. The same way they need warehouse, sales and customer service professionals, they’ll need web people as well to survive. This is also true for companies serving businesses. The demand for web engineering talent will come from every industry. This is nothing new. A McKinsey study published in 1998 coined the term, predicting that we would be engaged in war for talent for the next 20 years. On the entrepreneurial side, we now have dozens of startup factories like Y combinator, Techstars, Launchbox Digital, etc. that are helping engineers become entrepreneurs, producing hundreds of investor ready opportunities every year as a result. These accelerators also have the effect of stimulating entrepreneurship, driving talented engineers to leave their employer and start a company, resulting in the creation of thousands of companies for each hundred that make it into such programs. As the demand for great engineering talent continues to increase over the coming years, more and more will choose to start companies instead, capitalizing on low starting costs and continued excitement about the space, putting even more pressure on the supply. As a natural supplier of talent to the IT market, aspiring entrepreneurs and startups are now seriously competing with large IT companies as they need engineering talent to grow and succeed. I don’t see this lack of engineering talent supply issue to subside in the US until there is a major influx of talent in the system caused by new grads or immigrants. Obviously, the Startup Visa movement led by Brad Feld and Paul Kedrosky is meant to alleviate this problem.

What does this mean for you?

IT companies have two choices to meet their engineering talent needs: buy more startups earlier in their development or increase compensation for engineers to dissuade them from starting companies, joining startups, or leaving to a competitor. As long as engineering talent is their most important resource, it makes sense for large tech companies to spend more money in this area, whether through acquisitions with backloaded earnouts or by increasing salaries, bonuses and restricted stock grants. They have the cash and stock to do it. Both Google and Facebook have been active in this area, making dozens of talent acquisitions this year alone and in the case of Google, announcing across the board 10% raises. Even if the economy turns, I don’t expect this talent war to slow down much, as Apple, Google, Facebook and Microsoft have almost unlimited resources and are engaged in a turf war that none of them can afford to lose.

Entrepreneurs are well positioned if they have an interesting project and can recruit good people, although the amount of stock they will have to share to build their team may increase over the coming years. I don’t think the lack of talent supply in the ecosystem will have a huge impact on the cost of starting a company and getting to market validation as most engineers joining startups don’t do it for salaries anyway but for glory and the chance to work on a great project. Founding teams may get bigger to incorporate all the major roles that need to be filled from the get go. As long as they are offered enough equity to make it worth their while, good engineers should continue to join startups. On the funding side, capital sources will continue to outnumber good investment opportunities by a wide margin for a while. There is just too much money in the system at the early stage level. To protect against an eventual reduction in supply, especially at the growth stage, startups should remain capital efficient and try to get to market validation on $1M or less, and breakeven on $2M or less. Lean startups that are breakeven will also have a better chance of getting acquired, especially in tougher times. The best way for entrepreneurs to have options is to build a great team, ship great product, get happy customers and get to breakeven on as little money as possible. The world is yours if you can achieve that.

If you’re a web software engineer, the future is bright. Demand for good software and web engineers will outpace supply for years to come. We’re in a digital economy. There are hundreds if not thousands of markets that need to be reinvented using the new web, social, gaming and mobile paradigms. Companies large and small need to reinvent their business. There will be opportunities in startups, large web companies and traditional companies that can’t afford to let the web pass them by. As a web engineer, don’t be afraid to try the startup experience as you should be able to find a great job quickly if it doesn’t work out. Get involved in the open source community and stay current with the new technologies. Compensation should go up relative to other professions.

If you’re an angel, Super Angel or venture capitalists, things are about to get tricky, especially if you’re in an efficient market like Silicon Valley or investing in consumer web. Investors make money by investing in great entrepreneurs, bull markets, and inefficient markets where they have a competitive advantage. In general, the excess of capital in the market is driving valuations way up, making it difficult to generate a return. The talent wars should help maintain a steady stream of low valuation exits for years to come, but it’s hard for investors to generate consistent returns on those alone, especially as valuations are going up coming in. You need the big exits for the model to work.

Beware of the bull market. Most of the returns from the VC industry for the past 20 years occurred during the bubble of the late 1990s. Over half of the VCs in business today built their track record on this period. The key was to go in and out at the right time. This is called momentum investing. It’s a viable investment strategy in public markets when you can get in and out at anytime, but not as a venture investor. We are currently in a bull market in the web world. Unlike 1999, our bull market is backed by fundamental economics like revenues, but it’s still overvalued. It’s hard to make money in an efficient market when you overpay coming in. You need someone willing to overpay on the way out. It’s all about timing. I look at consumer web in Silicon Valley as an efficient market. No one aside from a select few has any sort of competitive advantage and that number is shrinking. Some of the accelerators like Y Combinator and Techstars are also efficient markets. With more and more capital flooding the market, this problem is likely to expand to other geographical areas like New York, LA, Seattle, etc. and other segments like BtoB, SaaS and financial services over the coming months, and years. Don’t get me wrong, some people like First Round Capital, Foundry Group and Union Square Ventures to name a few will generate great returns in this space, but many will struggle.
Find inefficient markets in which you have a competitive advantage. . Both Mark Suster and Roger Ehrenberg have great recent posts on the subject. There are many smart and successful entrepreneurs outside of Silicon Valley. There are many other massive markets outside of the consumer web space that are ripe for disruption and have clear business models. Those geographies and market segments are not overheated yet. Competition for talent isn’t as fierce. The angel and VC communities are not as robust. Valuations are reasonable. Be the partner who will give them access to Silicon Valley, senior management, business partners, customers and potential acquirers. It’s hard work but more likely to succeed on a consistent basis. Focus on value as opposed to momentum. Success should come from within. A growing business with products and happy customers will always be valuable, in good and bad times. The talent crunch will spill into these markets as well, creating many acquisition opportunities. IBM, Intel, Cisco, Oracle, HP, Dell, EMC, etc. have been aggressive acquirers and this trend should continue.

Interesting times indeed.

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